CAPITAL STRUCTURE

Capital Structure
 Capital Structure
This is concerned with the question as to
whether there is an optimal capital mix of debt
and capital which a company should try to
achieve.
There are three major theories:
 Net Income (NI) approach

 Traditional view

 Modigliani and Miller

Net Income Approach
 Suggested by David Durand
 Capital structure affect the value of the firm
 Change in the capital structure causes a corresponding
change in the overall cost of capital and the total value
of the firm
 Higher financial leverage will result in the decline
in the WACC
 Causing the increase in the value of the firm
 And the increase in the value of the firm
Net Income Approach
 Assumptions of the NI Approach
i. There are no corporate taxes
ii. The cost of debt is less than the cost of equity
iii. The debt content does not change the risk perception of the
investors
 The value of the firm
V = Ve + Vd
Where Ve = Market value of equity
Vd = market value of debt
Ve= NI/re
Traditional View
 The traditional view of Capital structure
 There is an optimal capital structure
 The company can increase its total value by a
suitable debt finance in its capital structure.
 Assumptions:
a) The company pays out all its earnings as
dividends
b) The leverage of the company can be changed
immediately by issuing debt to purchase
shares, or by issuing shares to repurchase debt
 Traditional View

Assumptions:
a) The company pays out all its earnings as dividends
b) The leverage of the company can be changed immediately
 by issuing debt to purchase shares,
 or by issuing shares to repurchase debt
c) The earnings of the company are expected to remain
constant in perpetuity
 and all investors share the same expectations
d) Business risk is also constant, regardless of how the
company invests its funds
e) Taxation, for the time being, is ignored
Traditional View
a) As the level of leverage increase, the cost of debt remains
unchanged up to a certain level.
 Beyond this level the cost of debt will increase
b) The cost of equity rises as the level of leverage increases
and financial risk increases.
 There is a non-linear relationship between the cost of
equity and leverage
c) The WACC does not remain constant
 falls initially as the proportion of debt capital increases
 Then begins to increase as the rising cost of equity
becomes significant
Traditional View
d) The optimum level of leverage is where the
company WACC is minimized.
Modigliani-Miller (MM) View
 Assumptions of MM view
a) A perfect capital market exists in which
 investors have the same information
 Upon which they act rationally
 To arrive to the same expectations about future
earnings and risks
b) There are no taxes or transaction costs
c) Debt is risk-free and freely available at the same
cost to investors and companies alike.
Modigliani-Miller (MM) View
 In 1958 Modigliani and Miller proposed
MM Proposition I
 The total market value of a company, in the absence of
tax will be determined by two factors
1. Total earnings of the company
2. The level of operating risk attached to those earnings
(The total market value would be computed by discounting
the total earnings at a rate that is appropriate to the
level of operating risk. The WACC)
Thus the capital structure has no effect on the WACC.
Modigliani-Miller (MM) view
 MM justified their approach by the use of
arbitrage.
MM Proposition II
1. The cost of debt remains unchanged as the

level of leverage increases

2. The cost of equity rises in such a way as to

keep the WACC constant.

Graphical MM view

The MM view would be represented on a graph as shown

below

Cost
of
capital
Cost of equity

WACC

Cost of Debt

D/E ratio
Modigliani-Miller (MM) view
 Summing up MM view:
 MM hypothesis is based on the idea that
 No matter how you divide up the capital structure of a
firm among debt, equity and other claims, there is a
conservation of investment value
 Since total investment value of a corporation depends
on its underlying profitability and risk.
 Total investment value is invariant w.r.t. relative
changes in the firm’s financial capitalization.
Market imperfections
 In 1963 MM modified their theory
 Admitted the effect of tax relief on interest payment to
the WACC
 Interest on debt is tax deductible
 Saving from tax relief on debt is called tax shield.
 They claimed that the WACC will continue to fall up to
100% gearing.
 This suggests that companies should have a capital
structure made up entirely of debt.
 This does not happen because of market imperfections
Market imperfections
 Value of the interest tax shield = (T x rd x Vd )/rd
 = T x Vd
 VL = VU + (TxVd)
 Vu = EBIT (1-T)/rU

 Taxes, WACC and Proposition II

 Ve   Vd 
re    rd  
 Ve  Vd   Ve  Vd 
 WACC(rA) =
Market imperfection
 re = rA + (rA –rd) (Vd/Ve)
 MM demonstrates that in the world with corporate
taxes
 re = ru + (ru –rd) (Vd/Ve)x (1-T)
 This results indicates a positive relationship
between the expected return on equity and debt
equity ratio
 It implies that the rA decreases as the amount of
debt increases
Market Imperfections
1. Bankruptcy costs
 One assumption of MM theory is perfect capital

market
 But in reality, at higher levels of leverage there is an

increasing risk of the company being unable to meet

its interest payment and being declared bankrupt
 At these higher levels of leverage the bankruptcy

risk means that required rate of return will be higher.

Market Imperfections
2. Agency Costs
 At Higher levels of leverage, there are also
agency costs
 Due to actions taken by concerned debt holders
 Restrictive covenants: limit to dividends and
minimum level of liquidity, by debt providers to
protect investments.
 Higher levels of monitoring
Market Imperfections
3. Tax Exhaustion
 As the companies increase their level of leverage
 they may reach a point where there are not enough
profits from which to obtain all available tax benefits
 Bankruptcy and agency costs will rise, but benefits of
tax shield will not rise sufficiently.
 So market imperfections undermine the tax
advantage of debt finance.
Optimal Capital Structure
 Financial distress costs are insignificant for a firm
with little or no debt.
 so if an unlevered firm adds a small amount of debt
 It benefits from the tax shield on debt
 Without incurring significant costs of financial distress
 As a firm uses more and more debt
 The tax savings are eventually offset by the higher
likelihood of financial distress
Optimal Capital Structure
 The point where these two factors offset each other is
where the firm value is maximized.
STATIC THEORY OF CAPITAL STRCUTURE
 A Firm uses debt financing up to the point where tax

benefits from additional debt exactly offsets the cost

associated with an increased likelihood of financial
distress.
 That is the optimal capital structure
 Optimal capital structure
 Minimum WACC
 Maximizes the firm value
Optimal Capital Structure
 Recommendations From The Static Theory of
Capital
1. Firms with higher tax rates should borrow more
as long as they don’t have other tax shields
2. Firms with higher risk of distress (due to higher
operating risks) should borrow less
3. Firms for which the cost of financial distress is
higher should borrow less